The Sentiment Signal Suggesting Stocks Could Go Flat

An extreme reading from the Investors Intelligence sentiment survey could point to a period of subpar returns for stocks

Senior Vice President of Research
Dec 19, 2016 at 8:31 AM
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Since the early November U.S. election, stock market momentum -- at the expense of the bond market -- has been the big story, with questions raised in the media about equities rising "too far, too fast." Moreover, in this space during the past couple of weeks, potential hesitation points have been pointed out -- such as Dow Jones Industrial Average (DJIA - 19,843.41) 19,000, which was sliced through like a knife through butter; and the S&P 500 Index (SPX - 2,258.07) 2,200 century mark, which is now 58 points below the index's Friday close.

Per the observations I made on Twitter during the past couple weeks, other round-number areas seem to have finally slowed the momentum, with the iShares Russell 2000 ETF (IWM - 135.91), which had shown leadership from the early November low, declining slightly last week. Moreover, equity benchmarks we did not discuss in recent weeks -- specifically, the S&P MidCap 400 Index (MID - 1,667.73) and NYSE Composite Index (NYA - 11,125.22) -- stalled at round-number year-to-date percentage gain levels of 20% and 10%, respectively.

In fact, MID's month-to-date high so far is at 1,698 -- just a couple points shy of the round 1,700 level. Like IWM, this index has also displayed leadership since the election.

MID daily 1216

"We move into this week's standard December options expiration week with the SPDR S&P 500 ETF Trust (SPY - 226.51) trading slightly above the $225 area... The $225 level coincides with S&P 500 Index (SPX - 2,259.53) 2,250, a half-century mark -- and such half-century marks have historically acted as magnets during trading range behavior and/or key pivot areas after a big advance or pullback... The importance of these half-century levels could be due to the heavy open interest that tends to build up on SPX and SPY options at these strike prices that represent half-century levels on the SPX. Coincidentally, the $225 level on the SPY is also around its 2016 10% YTD return level."
    -- Monday Morning Outlook, December 12, 2016

Last week, in addition to the Federal Open Market Committee (FOMC) interest rate decision, was also the expiration of standard December options. Indeed, the SPDR S&P 500 ETF Trust (SPY - 225.04) did hesitate around the significant 225 strike level, which coincides with the SPX 2,250 mark. This was not a major surprise, as the 225 strike was home to the last significant call open interest in the December series, some 5 points below the next heavy call strike at 230.

spy oi config 12-16

And as we said last week, throw in the fact that this area resides around the round 10% year-to-date return, and SPY's hesitation here makes sense. With a sell-off occurring in the immediate aftermath of the Fed meeting, the big call open interest at the 230 strike was never seriously challenged -- even though the potential for this was alive, with the Fed acting as a potential catalyst.

spy 30-minute 1216

Fortunately for bulls, stocks in recent days have only stalled at these round-number resistance levels, versus actually selling off. So, on the charts, the technical backdrop appears sound, punctuated by the recent all-time highs. Internally, breadth is suspect, as the number of advancers has declined, even with the SPX recently hitting highs.

spx breadth 1216

Moreover, we are seeing optimism come into the market, which usually occurs prior to a sell-off or trading range behavior. For example, newsletter advisor optimism, per a survey by Investors Intelligence (II), is at the highest level since July 2014, with the difference between the percentage of bullish advisors (59%) and bearish advisors (19%) at 40 percentage points. This differential is an extreme reading, per the chart below, and since 2011, sentiment extremes of this magnitude have typically preceded either trading range or corrective price action.

In fact, the bulls-minus-bears differential in the weekly Investors Intelligence poll ranks in the 93rd percentile of all other such readings dating back to 1972. Looking back over this time frame, we have quantified the historical price action of the SPX based on the percentile rank of the II bulls-minus-bears reading. The data suggests that the optimism isn't necessarily an alarm bell for bulls to exit, but it does suggest that the expected returns over the next days and weeks are flat, and far below the "normal" returns for various time frames (see the table below the chart).

investors intelligence since 1972 1216

If you are a short-term trader, be open to trades on both the short and long side of the market. If you are a long-term investor, do not disturb your bullish positions.

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